THE ASIAN-PACIFIC MARKET:
THE NEW MILLENNIUM

Presented at the Singapore Institute of Banking & Finance,
Singapore
November 26, 1996

I am pleased to be back in Singapore, amongst my friends from the Monetary Authority of Singapore and the SIMEX. In 1984, at the birth of the SIMEX I had the honor of handing this financial community what I then called "the torch of financial instruments" and admonished that you keep the flame burning. You have succeeded in this task. Indeed, in no small measure due to the success of SIMEX, the nation-state of Singapore is today the primary financial beacon in this sector of the world. But as you are aware, your work is unfinished.

About a month ago, Finance Minister Dr. Richard Hu, unveiled a new regional stock barometer, the Business Times Singapore Regional Index (BT-SRI) to internationalize Singapore's capital market even further. I applaud his actions. The BT-SRI, jointly developed by the Stock Exchange of Singapore (SES) and Singapore Press Holdings, will enable participants throughout Southeast Asia to better track the performance of their portfolios in Asia. As Dr. Hu stated, "the index will set in motion a virtuous cycle of attracting more large and reputable foreign companies to list on the SES."

I agree! Indexes and index markets have become indispensable tools in the ever-expanding equity markets the world over. And their symbiotic brethren—stock index futures—have achieved an even greater degree of indispensability in their role as equity risk management tools. Thus, I am heartened to learn that SIMEX plans to study the performance of the cap-weighted BT-SRI to assess the feasibility of a futures contract based on this index. I hope that the assessment proves constructive for I believe that a successful futures contract in the BT-SRI can prove to be another magnet for SIMEX trade.

Indeed, in 1982 when we at the Merc initiated trading of stock index futures with the S&P 500, we were very conscious that we were bringing to the fore a revolutionary financial tool that could catapult the CME well above all other exchanges in the world. This belief proved well-founded. The Merc's stock index futures markets have given our exchange several most coveted rewards: enormous recognition, dramatic growth, and business participants that previously were found exclusively in equity markets. But the world at-large was also rewarded. Stock index futures and options changed the manner and scope of equity markets. Not only have our derivatives markets led to innumerable new trading strategies, but they have led to the recognition that there exists a large liquid pool of risk takers alongside the traditional equity cash markets that can instantly accommodate hedging requirements. This has been a boom to all equity markets. Thus, it is no coincidence that volume in equity markets has grown in dramatic proportion since the initiation of stock-index futures; it is no coincidence that since 1982 mutual funds have become the most potent force in equity markets; it is no coincidence—the 1987 crash not withstanding—that the current U.S. bull market by most measurements began with the birth of stock index futures.

Of course the equity market is not the only market that has experienced dramatic changes. The metamorphisms occasioned by all financial markets during the past 20 years has been nothing short of phenomenal. World markets have expanded, globalized, integrated, disintermediated, and innovated at an incredible pace. These transformations resulted in enormous benefits for the industrial world, benefits that are nearly impossible to fully evaluate. Suffice it to say that, at a minimum, the advances in financial markets—particularly those of the derivatives markets—both on and off exchanges, have vastly expanded the pool of available capital in the world and allowed it to be more efficiently utilized to the benefit of all nations and nationalities.

There were related benefits as well. The breakdown of controls on capital flows contributed to a significant increase in world foreign investment, which in 1993 was more than eight times its 1975 level. This increased investment has contributed to the increase in trade, technology transfers, and the development of multinational corporations. In addition, world exports, instead of declining as was anticipated, increased fourfold from their 1975 level. Indeed, world trade has substantially grown as a percentage of a world output since 1987. Even in the trade-deficit-bound United States, exports have kept up with the world trend and increased as a percentage of gross domestic product.

But in becoming huge and innovative, with few exceptions financial markets have escaped controls traditionally provided by governments. This has been of concern to some regulators. Market forces and their participants now rule the global economy, wielding unimaginable financial power. It is estimated that the combination of world stock and bond markets, and markets in financial futures, options, and swaps options generate trading volume in the range of $10 trillion to $20 trillion on an annual basis. This does not include the foreign exchange market which by itself provides over a trillion dollars in daily transaction. Obviously, and most importantly, the reach of this enlarged pool of capital extends far beyond developed industrial countries and affects dozens of third world as well as emerging market nations.(1) This has been especially true with respect Latin America and Southeast Asia.

But one cannot discuss the changes in financial markets without underscoring that the primary catalyst for these changes has been technology. Technology, with its accompanying power of open and instant information dissemination, has altered every aspect of the markets we knew but a mere decade ago. We now live within a truly global, 24-hour financial marketplace which literally never closes. And information, propelled at lightning speed, has accelerated the velocity at which decisions are made. Windows of opportunity have grown increasingly narrow but have vastly multiplied in number. Orders are transmitted with nanosecond speed. The competitive demands resulting from these realities is currently high on the agenda of every exchange in the world. It is also one of the most-discussed topics by federal regulators as they seek to protect the standing of their nations' markets into the next millennium.

Technology has also opened the flood gates of product innovation. The last 20 years have seen the development of a host of new and highly technical financial instruments. These are based on complex mathematical and statistical models. Financial engineers using their computers comb world markets searching for inefficiencies, financial exposure, and investors' dilemmas, to create synthetic financial instruments to solve the perceived risks. Derivatives, the financial equivalents to particle physics and molecular biology, have transformed investment methodologies from all-encompassing traditional strategies to finely-tuned modern portfolio theories. Simple futures contracts in foreign exchange, Eurodollars, and bonds, first launched in Chicago in 1972, have evolved into complex swaps and swaptions, strips and straps, caps and floors.

Yet we are about to take another giant leap in the technological history of our planet. Everything within the technological revolution of the last two decades is about to become old, if not obsolete. For technology is poised once again to take a quantum leap. The computers that wired the world in the mid-1980s, are about to go wireless. Today's cyberwizards have combined the sorcery of electrical and electromagnetic waves, and propelled them at the incredible speed of 300 million meters per second, about three quarters of the way to the moon with every second. In doing so, they have produced an invisible wave of energy that can carry a computer command, the human voice, or virtually any program including market information, quotations, analysis, and orders from anywhere to anywhere. The new technology will create a world in which applications impossible with wires will result in not just a series of new technological marvels, but a spectacular lifestyle emancipation.

Exchanges must be ready to embrace these changes and take the indicated initiatives. Were we at the Merc not willing to do so back in 1982, mutual offset with the SIMEX would never have occurred. As I say in Escape to the Futures, the trick is never to be trapped by what Milton and Rose Friedman called "the tyranny of the status quo." Indeed, those exchanges who fail to embrace state-of-the-art technological capabilities in their transactional and clearing processes are destined to be relegated to a secondary role in global markets.

Most important for Singapore and this part of the world, we are about to enter the age of the Pacific. A recent poll by Institutional Investor revealed that there could be as much as nine trillion dollars of investible funds in Asia, larger than the pool of funds in Europe. This pool of funds has fueled growth in Asia's capital markets and the potential for continued growth is overwhelming. Tangentially, with half the world's population in Asia, this region has the highest potential for developing successful futures markets.

Already the futures markets in Asia have grown substantially in terms of volume and new products. Yet many obstacles remain. As a relatively new industry in Asia, many governments in the region fear that the trading of financial futures by individuals and corporations will undermine their ability to control interest rates and rates of foreign exchange. It will, but I submit the benefits will far outweigh their loss of control.

Futures markets in Asia fall into three categories: open, semi-open, and closed. Examples of open markets are Japan, Australia, and Hong Kong. These markets not only allow foreign firms to become members of their exchanges, but also have domestic products that foreigners can trade. Singapore, Taiwan, Malaysia, and Korea belong to the semi-open category. These markets do not have domestic products (Singapore and Taiwan), or have restricted foreign access to the markets (Korea and Malaysia). The rest of the Asian countries fall into the closed category. For example, foreign investors are not allowed to trade futures contracts and foreign firms cannot become members of the futures exchanges in China. Other countries such as the Philippines, Thailand, and Indonesia do not yet allow futures trading, but all are moving in that direction.(2)

The reason is axiomatic. The biggest difference between rich and poor countries is the freedom and efficiency with which they have used their resources. Free and efficient capital markets ensure that resources are allocated wisely and foster the movement of savings into productive investments. The more efficient the system, the better the allocation of these resources. The more productive the investment, the higher the rate of growth. Thus, while work-force productivity is the result of technological application, education, and sophisticated work skills, capital productivity is the result of efficient use of capital. Futures markets and their cousins in the OTC derivatives markets are striking conduits of efficiency.

Efficient markets lead to tighter bid-ask spreads, higher volumes of trading, and greater market liquidity. Such markets tend to reflect truer price values, giving investors the confidence that the markets are priced correctly. Participants can convert securities they hold into cash, or vice versa, at reasonable costs and speeds. The bottom line is that efficient markets have a favorable impact on the cost of capital. By providing liquidity and offering entrepreneurs—both local and foreign—with an ability to be protected against financial risks, derivatives, both on and off exchanges, increase their willingness to invest. This is especially consequential for emerging economies since real efficiency in capital markets cannot be achieved unless their markets leave their segmented past and become integrated internationally.

In a segmented market, volatility is usually very high, transaction costs are expensive, and inherent market risks are difficult to hedge for both foreign and domestic investors. Since expected rates of return are linked to local market volatility, the cost of capital in segmented markets increases. In an integrated market, on the other hand, the expected rate of return is linked to the way the security interacts with a geographically broader investment portfolio. This tends to reduce volatility and lower the cost of capital. Thus, an integrated market provides a local economy with dual benefits by attracting foreign capital for domestic expansion and offering domestic investors opportunities for further diversification. The foregoing reality is no doubt what motivated Dr. Hu's recent announcement. Market integration for Singapore will lower the cost of capital and reduce the hurdle rate that new investments must attain. With more investment come additional jobs, augmentation of human capital, and economic growth.

But Singapore is not alone to understand these truths. The prize is great, as those of us in Chicago, the capital of futures markets, have demonstrated. Singapore will face some heated competition in it quest to remain the dominant center of futures trade in this region. Allow me to briefly examine what your competitors are doing:

First, the two Chicago exchanges are not sitting idle. The Merc has created the Emerging Markets Division and while until now it has concentrated on Latin America, it may soon turn its attention to Asia, beginning with the Taiwan Stock Index. The CBOT has taken the role of providing consulting services to developing exchanges in return for part ownership. And in Japan, the financial colossus of Asia, futures markets have recently grown in spite of Japan regulatory constraints. Volume on the Tokyo Grain Exchange has surged threefold in 1996. If the de-regulatory big bang comes to Japan as the new government recently promised, then this country's formidable financial strength will again become a serious contender for futures market dominance in Asia.

Hong Kong is also not sitting still. With its eyes focused on it greatest rival, Singapore, the Hong Kong Securities and Futures Commission has reformed its regulatory environment in the hope that the new comprehensive agency will retain its regulatory power even after Hong Kong returns to China next year. In the meantime, the Hong Kong Futures Exchange (HKFE) successfully launched its long term Heng Seng options contracts. Its plans to trade cash currency options on its electronic system and its link up with the Philadelphia Stock Exchange to form a 24-hour market is an ambitious and laudatory idea. Similarly HKFE's arrangement with the New York Mercantile Exchange (NYMEX) for its members to obtain NYMEX terminals is also a praiseworthy innovative step geared to keep the HKFE in the forefront of futures trade.

In Korea, the Korean KOSPI 200 stock index market has maintained a respectable daily average of 3,200 contracts since its inception of futures trade in May of this year. This volume, while not earthshaking, is bound to grow as investors learn more about the use of their stock index market and especially if current restrictions on foreign trade are diminished or removed. Additionally, in the next year or two we can expect the birth of a new financial futures exchange in Korea for the listing of traditional interest rate contracts and perhaps foreign exchange.

While the new futures markets in Malaysia have thus far been disappointing, I cannot help but believe that they will continue with efforts to stimulate trade and educate their financial community. In Taiwan, preparation for its launch of a domestic futures exchange under the guidance of the CBOT is in full throttle. The exchange plans to open in mid-year 1996 and trade is expected to be brisk from the start. Its TAIEX stock index is in great demand with the CME angling to list its own Dow Jones-sponsored Taiwan index contract.

China's futures markets have had their share of ups and downs. Nevertheless, futures trading in China has grown substantially. Recently, I spent some considerable time visiting first-hand some Chinese futures markets and discussing futures with their financial community. I left with a highly favorable impression and the knowledge that their markets are moving towards a technological venue. Several exchanges have created satellite networks to allow their participants in various parts of China to link directly to an exchanges main-frame. The resulting efficiency needs little explanation.

Presently there are 15 nationally approved Chinese futures exchanges trading solely agricultural products and metals. They are all in intense competition with each other and in my opinion the overall number of exchanges will fall as they are consolidated or go out of business. But make no mistake about it, the remaining exchanges will be very successful. Remember that the Chinese futures industry is only four years old and already has traded in excess of 617 million contracts with a dollar value of over one trillion in 1995. On some exchanges, record trading volumes exceed two million contracts. All of this without financial contracts which had a rough beginning and were banned, only temporarily I am certain. The effect of Hong Kong and the eventual convertibility of the Chinese Reminbi can only act as constructive catalysts in the development of China as a formidable futures market competitor.

But allow me to conclude by returning to Singapore and the SIMEX. Singapore can be justly proud of its stable and expanding economy in Southeast Asia. There are many factors that contribute to this strength: Singapore's political stability, its developed infrastructure, its sizeable foreign exchange reserves, and its sound economic fundamentals to name just a few. Indeed, the Singapore dollar has greatly benefited from this environment and has assumed a safe-haven status. For instance, Singapore provided a shelter for capital inflows in times of currency turbulence such as that surrounding the Mexican peso crisis in early 1995 and the Taiwan Strait tensions in March 1996. As testimony to its established and well-regulated financial market, Singapore has become the fourth most active foreign exchange center in the world after London, New York and Tokyo.

And as I said at the outset the SIMEX in no small measure has been a contributor to Singapore's financial success. It must continue to build on these past successes and the government of Singapore should assist this process—the Barings Bank failure notwithstanding. Indeed, the Barings failure had a silver lining. It highlighted for SIMEX and other Asian exchanges the need to strengthen their regulatory and capital requirements. It underscored for Japanese and exchanges around the world the need to conform to international futures market rules, procedures and standards. We are all the better for it. But we must not allow the Barings failure to become a psychological block to futures market growth. While tightening of futures regulation and increased capital requirements at the SIMEX were warranted, these requirements must not become so onerous as to unduly drive up the cost of doing business at SIMEX. All such reforms must be balanced and weighed against the risk of overreaction. If not, they will turn out to be a case of throwing out the baby with the bathwater.

Lest we forget, the Barings Bank breakdown, the Daiwa Bank debacle, and even the Sumitomo copper scandal were primarily caused by a lack of internal risk management controls at the banks involved. The derivatives markets on which the money was lost were not the culprits. Since time immemorial, rogue traders have been all too common in business, and management must know to protect itself from their criminal actions. The banks involved had little, if any, controls to prevent the unauthorized actions of its rogue traders. The first order of business at every international company is for its management to have a good understanding of the derivatives market, know whether its prospective positions are a speculation or a hedge, be certain that there are adequate risk controls to prevent fraud or unauthorized trading, and ensure that a system of checks and balances are in place to measure the market exposure involved. Surely, failure of these measures by international market participants should not be placed on the doorstep of futures and options markets.

If we so recoil from Procter & Gamble, Orange County, Metallgesellschaft, Barings Bank, Daiwa Bank, Sumitomo or similar debacles yet unknown that we enact Draconian rules to prevent their occurrence, if corporate boards shrink from the use of derivatives because of fears of consequential losses to their corporate bottom line, or sanctions by regulators, then at best corporate profits are headed south, and at worst civilization has hit its top.

Indeed, make no mistake about it! In our global market environment—driven by constant and changing market risks, instantaneous information flows, and sophisticated technology—derivatives and futures exchanges are essential. And for emerging economies they are indispensable instruments in the development of free and efficient capital markets.

Thank you.

____________________

     (1) Roy C. Smith, "Risk and Volatility," The International Politics of Global Finance, The Washington Quarterly, 1995 Autumn, Vol. 18, No. 4, P. 117.

     (2) "East Meets West: Futures Challenges in Asia," Paul Shang, Senior Director, Asian Development, Chicago Mercantile Exchange, p.2

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